Deep Dive : CDOs in DeFi Space

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What does the infamous bad boy of the 2008 financial crisis have to do with Decentralised Finance?

What are CDOs?
CDOs stand for Collateralised Debt Obligations, and is a structured financial product that has been employed at scale in traditional finance for many years.

The defining mechanism of a CDO is to pool together cash-flow generating assets such as mortgage loans and bonds, and repackage them into tranches of different risk levels, and corresponding returns. Note that a CDO is therefore considered a financial derivative as it derives its value from the underlying pool of cash-flow generating assets.

CDOs remain a popular structured product in traditional finance.

Why even make CDOs?
The utility of creating a CDO essentially lies in its repackaging of returns and risk, as investors can now choose to subscribe to a specific class of risk/returns that is to their liking, rather than settle for the unaltered risk/return profile of the underlying asset pool. The magic occurs through an efficient waterfall payout system. Senior tranches (more risk protection, less yield) gets paid their returns first, while junior tranches (less risk protection, more yield), gets paid last. As such, there is an effective tradeoff of risk and return between senior and junior tranches.

Imagine the possibilities. Institutional investors that are previously too risk averse for a particular yield-generating pool can now obtain inherent downside protection for less returns. Adventurous investors that would like leveraged returns with the added risk that comes with it now has a cheap (and efficient) way to leverage their position. Everyone wins.

Pitfalls of Tradfi CDOs and why we are different

Ryan Gosling with Jenga Blocks; explaining how CDO’s was used to package bad subprime mortgage loans.

Unfortunately, CDO’s was also the financial instrument of choice used by banks to package subprime mortgage loans (read: bad yield generating pools with incorrectly calculated risk), which eventually caused the US housing market crisis, and the subsequent Great Recession of 2008–2009.
CDO also happens to be the namesake of our platform (CDO.Finance).
Here’s why we think Decentralised Finance is ripe and potentially more suitable for a CDO product.

CDO.Finance and DeFi Money Markets
While decentralised money markets comes with its own set of risks (e.g smart contracts vulnerabilities), liquidity pools in decentralised finance are highly collateralised due to its trustless nature. This dramatically reduces default risk of the underlying cash-flow generating assets, and the likelihood of a mass default like what happened during the US housing market crisis.

In addition, while financial structuring is highly expensive and hence targeted towards institutional investors in traditional finance, an on-chain CDO with algorithmically driven outcomes presents an opportunity to offer efficient and cheap risk protection and yield leverage to the masses, with the added bonus of not needing third-party remedial action like taking on insurance or paying transaction fees to borrow for leveraged farming.

While the nascent growth of decentralised financial services have been breathtaking to behold, we also believe that there is further room to grow if we are able to create derivative DeFi products off the existing base of money legos such as decentralised exchanges and lending platforms, that would boost inclusiveness by catering to participants of varying risk and return appetites. Through our product offerings, we see benefits for both risk-averse investors and capital-constrained investors looking for effective yield leverage. So, what are you waiting for?

Visit our website: https://cdo.finance
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